Pages

Thursday, September 11, 2014

No country for old money

by The Economist

If Scotland gains independence it will need a new currency and a new central bank

WHEN it comes to money and banking, no country has a richer history than Scotland. It was a Scot, David Hume, who in a 1748 essay set out the first coherent theory of the links between money, inflation and growth. And it is a Scottish idea, the joint-stock bank that, starting in the mid-1800s, became the backbone of global finance. Yet Scotland’s monetary future is as uncertain as its past is proud. Nationalist leaders say that if voters opt for independence in a poll scheduled for September 18th, the country will retain the pound in a currency union with the residual United Kingdom (rUK). That is a terrible idea.

The currency union that Scotland’s nationalist party, the SNP, envisages would be similar to the euro area. Sterling notes and coins would continue to circulate in Scotland, with the Bank of England setting a single interest rate for both countries and standing behind Scottish lenders in times of crisis. Such a union would eliminate exchange-rate risk and the cost of currency conversions, bolstering trade. Since the trade in goods and services between Scotland and rUK ran to £110 billion ($178 billion) in 2013—around two-thirds of Scotland’s GDP—the SNP reckons a sterling union would be best, both for Scotland and UK.

While trade is important, other factors matter too. In an influential paper published in 1961 Robert Mundell of Columbia University set out a set of tests for shared currencies. In an “optimal currency area” the factors of production—capital and labour—must be able to move freely. A sterling zone would pass this test, with its common language and many internal migrants. Capital would flow freely too, with the intertwined banking sector linking savers in one country with borrowers in another.

But a sterling zone would face big problems. Its members’ business cycles are reasonably well aligned, but not perfectly in step (see chart 1). That means that as it is, monetary policy is often too tight on one side of the border and too loose on the other. This divergence is likely to increase, since the budgetary transfers and shared fiscal policy that help to synchronise the two economies would cease. The SNP is planning to increase spending by 3% a year in Scotland, whereas the Conservative-led government in Britain wants to balance its books by 2019. Yet Scotland already has a bigger deficit than rUK, and its fiscal position is forecast to worsen as its population ages. Lacking a common fiscal policy, the sterling zone could easily become a mini euro area, with Scotland in the part of Greece. That explains why all three unionist parties oppose this option, and why the Bank of England’s governor, Mark Carney, called it “incompatible with sovereignty” in a speech on September 9th.

If the rUK stymies currency union plans, the SNP claims it will continue to use the pound anyway. This option—sterlingisation—is certainly feasible: there are 11 nations that use another country’s currency informally according to a recent IMF study. Kiribati, a Pacific archipelago, has used the Australian dollar since 1979. Montenegro, Kosovo and Andorra all use the euro despite not being members of the EU. Ecuador and El Salvador use the American dollar.

But there are two big problems with sterlingisation. With the Bank of England no longer responsible for Scotland, monetary policy would be set solely for rUK. If Scotland started to boom or slump but rUK was running well, the bank would not respond; the volatile oil industry means this is quite likely (see chart 2). The implications for Scotland’s financial-services industry could hardly be worse. Scotland is host to a large financial sector, which contributes 12.5% of its GDP. With no central bank supporting them, its banks and insurance companies would be seen as riskier investments and the cost of their borrowing would rise. Many would shift their headquarters to England taking highly paid staff and tax revenues with them.

Taking a punt

The best option sounds most radical: a new currency and new central bank. It is actually a very common step: 28 new central banks have been set up in the past 25 years. They sprang up rapidly in the 1990s as former Soviet and Yugoslav states gained independence. Iraq established a new bank and currency in 2003. Most recently Crimea has been attempting to set one up.

These innovators give blueprints Scotland could follow. When Estonia gained independence in August 1991, the government decided to create a new currency to replace the rouble. Less than a year later, in June 1992, deposits held in Estonian banks were redenominated, from roubles to kroons. Special counters at the new central bank were opened to allow residents to swap the old currency for the new one. As a show of confidence in the kroon, residents were also permitted to switch roubles for German marks, a strong currency. The scheme, reviewed in a 2002 IMF paper, worked well: the switch to a new central bank and currency took a week.

An independent Scotland should be able to follow this example. It will have more time to plan: fully 18 months between the vote and independence, which would come in May 2016. Scottish notes already circulate, and production could easily be scaled up. The new country’s share of Britain’s foreign-exchange reserves—around £9 billion—would provide credibility.

Deciding how the new currency should be managed would be more complicated. Poland and the Czech Republic quickly adopted inflation targets, allowing their exchange rates to float. But in order to smooth trade in the new country’s early years, it would be better to fix the exchange rate against the pound, according to Angus Armstrong and Monique Ebell of NIESR, a think-tank. This would require the SNP to rein in its spending plans. If it did not, Scotland’s expanding deficit might prompt a run on the new currency. But at least such austerity would be in support of a gleaming new currency, rather than to keep in step with grubby old English money.